Economics

A Worldwide Trail of Failures

by Janice Shields

A COMPANY'S ACCOUNTANT is entrusted to record information about financial
transactions, summarize the data and prepare reports for the public based
on rules established by the profession and government. Unfortunately, the
accountant possesses a bag of tricks which enables him or her to manipulate
financial data to make the company look healthier than it is. The process
of artificially pumping up net income or net assets is known as "cooking
the books."

The company hires external auditors as independent watchdogs to
assure the investing and lending public that the financial statements are
free of material misstatement. The auditors are supposed to review the
company's financial statements and internal controls and issue opinions
about the quality of the reports. Auditing standards are also established
by the profession and government.

The "Big Six" auditors are the major players in the worldwide auditing
game. Headquartered in the United States, these companies are organized
as partnerships, so they are not required to disclose information about
their operations to the public. A spokesperson for one of the Big Six,
Arthur Andersen, even refuses to identify the countries in which the firm
operates, claiming it is proprietary information.

The Big Six firms have been key players in a recent spate of audit failures
around the world which are beginning to undermine the internal system of
accountability on which the business world relies. But instead of focusing
on improving their practices and regaining the public's trust, the Big
Six have launched a full-scale campaign to reduce their liability for failed
audits.

Auditing firms claim that they are sued not because of bad audits, but
because, unlike their bankrupt clients, they have the money to pay aggrieved
shareholders and other creditors. Testifying at an August 1994 U.S. House
of Representatives committee hearing on a bill that would have limited
auditor liability, J. Michael Cook, chair and chief executive officer of
Deloitte
& Touche explained, "We are joined in the suit because ... we are
viewed as a ędeep pocket' whose supposed resources make the litigation
financially worthwhile to the plaintiff's lawyers." He admitted that "mistakes
were made" by the auditing firms, but recommended that the hearing "should
not focus on finger-pointing about errors in the past."

S & L complicity

Deloitte & Touche is hardly well positioned to argue for letting
auditing bygones be bygones, however. U.S. government regulators have connected
the firm to a number of savings and loans failures.

In March 1994, Deloitte & Touche agreed to pay $312 million to settle
$1.8 billion in lawsuits and other claims brought by U.S. bank regulators.
At the time, the Office of Thrift Supervision (OTS) issued a 120-page report
detailing the firm's alleged violations. Among the OTS's allegations:

Franklin Savings Association improperly deferred recognition
of at least $119 million in losses on financial futures contracts. According
to the OTS, even though Deloitte & Touche was aware of Franklin's improper
accounting practices, Deloitte's audit opinion declared that the financial
statements were fairly presented in conformity with generally accepted
accounting principles.

Columbia Savings and Loan Association classified its bond portfolio
as an investment account, but should have classified it as a trading account.
(Gains and losses on investment accounts are recorded in the accounting
records when the investment is sold; gains and losses on trading accounts
are recorded when the market value changes.) As a result, Columbia recorded
$45.3 million in gains on sales of corporate bonds even though the bank
actually had unrealized losses of $159 million. (Trading account losses
are recorded when the market price of the bonds drops, even though the
losses are unrealized until the bonds are sold.) According to the OTS,
Deloitte & Touche failed to seek and examine competent evidence and
instead accepted Columbia's classification and method of accounting for
its bonds.

Deloitte failed to review and analyze properly City Federal Savings
Bank's allowances for loan losses, which are established to reflect estimates
of outstanding loans that will not be collected. It therefore failed to
discover that City Federal's allowances were understated by at least $55
million.

Deloitte & Touche permits its auditors to discard preliminary
documentation prepared in connection with audits of insured depository
institutions. In violation of generally accepted auditing standards, adequate
records of the work performed and procedures applied did not exist because
information from the destroyed documents was not included in the audit
workpapers.

Deloitte & Touche consented to the OTS's order without admitting
or denying any of the allegations.

Worldwide failures

The audit failures illustrated by Deloitte & Touche's shady
past are not unique to the United States. The Big Six have settled and
face charges around the world:

In a letter to civil servants, the chief accountancy adviser
to the British Treasury warned against awarding public sector contracts
to 13 Deloitte & Touche professionals. The blacklisting is believed
to be connected to the government's legal efforts against the firm to recover
$234 million that the government paid investors in Barlow Clowes, a fund
management company that Deloitte & Touche audited and which later collapsed.

In Ireland, Ernst & Whinney (now Ernst & Young) reached an
out-of-court settlement for $118 million with AIB Group, Ireland
's largest bank and administrator of the Insurance Corporation of Ireland.
AIB accused Ernst of negligence when the bank discovered that an insurance
company, audited by Ernst, that it had purchased just 12 months previously
faced serious and unexpected losses on its underwriting business.

KPMG
was accused of faulty auditing which contributed to the $2.1 billion crash
of Tricontinental, the merchant-banking arm of the State Bank of Victoria
in Australia.
The firm reached an out-of-court settlement for $106 million, but claimed
that it had conducted its audit properly and that the audit did not extend
the problem which led to the bank losses.

The Spanish Institute of Accounting and Auditing recommended
that Coopers & Lybrand be fined $300,000 due to alleged infringements
of accounting norms in its audits of the Kuwait Investment Office's Spanish
holding company, Torras Group. Torras' accounts, initially audited by Coopers,
had shown profits of $31.8 million. At the request of Torras' new management,
Coopers & Lybrand performed a subsequent audit that reported losses
of $218 million. Coopers denies negligence, arguing that its previous audit
report had included "qualifications," or concerns about the company's accounting
practices or internal controls.

In the United
Kingdom, groups of Lloyd's of London investors, called "names," have
sued Ernst & Young and have authorized legal proceedings against Arthur
Andersen for alleged negligence in their auditing of Lloyd's. The names
claim in a suit that the auditors "were negligent in that they failed to
prevent under-reserving in earlier years of account, failed to identify
the inadequacies of the reinsurance policies, and failed to identify the
inadequacies of the manner in which the underwriting affairs were being
conducted." The riskiness of the operation was therefore unknown. Ironically,
the auditing firms' professional indemnity insurance is underwritten at
Lloyd's - so the names may be suing themselves.

Who examines the examiners?

At times, the Big Six find themselves on opposite sides of audit
cases. For example, in the United Kingdom, Deloitte & Touche received
a writ from Price Waterhouse, the administrators of the close-out of failed
computer leasing company Atlantic Computers, over an audit of the company.
Price issued the writ because the firm expected legal action by Ernst &
Young, the administrators of Atlantic's former parent company, British
& Commonwealth. Ernst & Young alleged that Atlantic had misstated
its financial position when Atlantic was purchased by British & Commonwealth.
In a simultaneous British case, the plaintiff/defendant roles have been
reversed: Price Waterhouse faces approximately $12.5 billion in legal claims
from the Deloitte & Touche liquidators of the collapsed Bank of Credit
and Commerce International over Price's audit of the bank.

In Italy, shareholders in the agrochemical group Ferruzzi Finanziaria
and its industrial subsidiary Montedison plan to suePrice Waterhouse in
the wake of the administrator of Ferruzzi and Montedison's finding of serious
oversights in Price Waterhouse audits of the group's accounts over a number
of years. He outlined a catalog of accounting malpractices, including:
an irrecoverable credit of $261 million to a company in the British Virgin
Islands, recognition of revenues of $146 million on nonexistent sales and
huge undocumented payments to offshore companies, supposedly for consulting
work. Many of the accounting irregularities were brought to light by fellow
Big Six firm Deloitte & Touche.

But with Big Six firms alternatively filing and facing charges involving
their fellow Big Six firms, questions of independence inevitably arise:
are the firms actually shielding each other? In the United States, for
example, First Home Savings Bank filed a lawsuit alleging that KPMG and
Deloitte & Touche had conspired to cover up substandard audit work.
The lawsuit accuses Deloitte & Touche of negligence in failing to detect
an embezzlement of $6 million. For two years, Deloitte & Touche repeatedly
refused to turn over key documents and finally said that a significant
portion of them had been destroyed in a fire. First Home claims in its
lawsuit that KPMG's initial report on Deloitte & Touche's audit work
had stated that Deloitte had "failed to exercise due professional care
in the performance of its examination." The lawsuit also alleges that KPMG
removed the negative conclusions and agreed not to make any negative statements
about Deloitte's work, even if KPMG discovered negligence by the accounting
firm. KPMG and Deloitte deny the conspiracy charges. According to a KPMG
spokesperson, "The client obviously got a report from us that they didn't
like and have now resorted to making absurd charges against us."

Seeking relief worldwide

As the Big Six face and file mounting charges of audit negligence
worldwide, they have banded together to pressure national governments to
reduce accounting firms' liability for bad audits. The firms claim that
shareholders and other parties injured when a company fails sue the auditors
because the auditors are believed to have "deep pockets" - money to pay
settlements.

In March 1994, with heavy backing from the Big Six, Christopher
Dodd, D-Connecticut, introduced the misnamed Private Securities Litigation
Reform Act of 1994 in the U.S. Senate. If passed, the legislation would
have made it much harder for stockholders to bring suits against those
responsible for company losses - including not only boards of directors,
but auditors. Specific provisions of the bill would have:

excluded small stockholders from filing claims;

imposed the winner's fees and costs on the losing party if the
loser refused to proceed under an alternative dispute resolution procedure,
thus making participating in a class action suit too risky for many victims;

required plaintiffs to demonstrate the state of mind of each defendant
at the time the alleged violation occurred;

modified the joint and several liability rule to require that damages
be proportioned according to each party's degree of responsibility. (Joint
and several rules assume that a fraud could not have occurred if at least
one of the participants had revealed its existence. Therefore, all participants
are equally responsible for the outcome of the fraud and each is 100 percent
liable for any damages. The proposed modification would mean injured plaintiff
shareholders in a bankrupt company could not recover the full cost of their
damages from the audit firms which failed to uncover improper accounting
practices that contributed to the company's bankruptcy.); and

limited the time period in which an action for loss could be launched.

The bill did not reach the floor of the Senate, but accountants are
hoping for favorable action in the next session of Congress. To that end,
the Big Six and their trade association spent $2.3 million in campaign
contributions to support House and Senate candidates in the recent election.
The largest slice of the Big Six action came from Ernst & Young's political
action committee (PAC), which paid a total of $346,210 to 283 federal candidates.
The biggest winner of the accountants' PAC payout was Representative Billy
Tauzin, D-Louisiana, who introduced a House bill similar to the Senate's
last session; he received $70,000.

On the other side of the globe, the New
Zealand Society of Accountants is pushing for a similar set of proposals
to limit auditors' liability. The Society has moved away from its original
idea of a liability cap. Instead, it has proposed a wish list of measures,
including:

the incorporation of accounting firms, which would insulate
auditors' personal assets from liability suits;

modification of the joint and several liability rules for accounting
firms;

introduction of the concept of contributory negligence for the
assessment of losses; and

a cap on the amount of time in which victims could file claims.

Those in the New Zealand government "are going to have to do something,"
a partner at Ernst & Young told The Accountant, calling the
mounting negligence claims against auditors "absolutely ridiculous."

Investors strike back

Investors are starting to fight back against auditing failures
and the auditors' political offensive. For example, fed up with the state
of auditing in Canada, the Canadian Investor Protection Fund, a $75 million trust established
in 1969 by Canadian stock exchanges, has started to develop its own auditing
examination; only auditors who pass it will be permitted to audit Canada's
brokers and investment dealers. In addition, the Fund is revising its uniform
audit instructions and plans to spell out more forcefully how extensive
audits must be before auditors can vouch for companies' accounting practices.

According to Donald Leslie, the Fund's president, "We have found that
the quantity of [audit] work has declined to the extent that the statistical
probability of an auditor detecting a material error, if it exists, is
now often less than the flip of a coin - or 50 percent. ... Over the past
20 years, [the amount of work done in an audit] has been gradually reduced
by perhaps as much as 50 to 75 percent." He claims, for example, that an
auditor used to inspect inventory at 10 client locations, but now might
count it at only three.

Meanwhile, working counter to the Fund is the Canadian Institute of
Chartered Accountants (CICA), which is calling for the standard package
of reforms, including modification of the joint and several rule and incorporation
and other limits on the liability of individual partners. According to
CICA, "We believe that the public's interest is best served when management,
directors and auditors can play their respective roles without fear of
unreasonable liability."

The international auditing firms are supposed to serve as independent
watchdogs, exposing corporate abuses worldwide. But they are failing to
live up to the level of public trust that their profession should engender.
The changed perception is well illustrated by Donald Leslie, president
of the Canadian Investor Protection Fund, who claims, "Twenty years ago,
when I looked at audited financial statements, I was able to put a lot
of faith in them. Now, I don't trust them at all."

The Big Six Auditing Firms and the Number of Countries in which they
Operate